ABC Accounting for Long term Debt pt 7 - YouTube

Welcome back to our intermediate financial accounting class. Over the last

few segments, we've been talking about long-term debt, and the way it shows up

on our income statement and our balance sheet. We've talked about the importance

of debt finance, and we've talked about how we do journal entries for bonds and

for mortgages, we've talked about retirements, and conversions, and done all

sorts of examples to help solidify the concept of how we treat debt for

financial accounting purposes. Now to wrap up this discussion, we need to

talk about one last topic, and it's one we've alluded to already in our very

first segment, but now I want to talk about it in a little bit more

detail, and that's the fact that companies try to shift as much debt as possible

off of their balance sheet. It's not because debt is bad, debt is actually a

good thing. It gives extra financing, it keeps the owners from having to provide

all those extra funds, it provides a financing source that you can pay back

with just interest, you don't have to give back interest and part of your

revenue stream, right? The profit that belongs to the investors. But it still

has a negative connotation for a lot of investors, because of the risk associated

with default. So companies have this tendency to try to slide it off. We call

it "off-balance sheet financing." And companies actually have a lot of reasons

why they think it's appropriate. We're going to talk about some of these

reasons why companies think it's appropriate to do off-balance sheet

financing. Now I'm not trying to convince you that's good or bad, I just want to

make sure you understand the logic that companies are using to argue with FASB

about whether or not different liabilities should show up on their

financial statements. Keep in mind: this has become such a hot issue, and there's

so much push back and forth between companies, and regulators, and auditors,

and academics that it really has become a key concept in our discussion of debt.

So here is the logic that companies use when arguing with FASB, and with others

who are trying to push them to report more than they're currently reporting on

their balance sheet, as a long-term debt balance. Their first

argument is that it actually improves the quality of the balance sheet if we

leave some of the debt off. And that allows us to get

easier financing. Now when we talk about quality being improved, we're not talking

about quality as in it provides more information, we're talking about quality

as in it looks better, and if our balance sheet looks better, we can get easier

financing. Easier financing is better on the bank, because they don't have to

spend as much money trying to figure out if we're good investment or not. It's

better on our investors because they don't have to pay as much to the banks

so they get to keep a larger share of the profits. It's better for us as

management, because we don't have to waste our time trying to get the

financing that we need. So that's one argument, the second argument is it makes

sure we don't violate our loan covenants. A lot of loan covenants have a

restriction on the debt that you're allowed to show, so you can only have X amount

of other long-term debt beyond this loan, or something along those lines. So

companies that can shift some of this debt off their balance sheet, they keep

from violating their debt covenants, which saves the bank a lot of time and effort

to recall, they don't have to do as much analysis, and we don't have to try to

renegotiate. It's always better for our owners if they don't have to pay the

fees associated with a debt recall, or have our credit rating downgraded. The

final argument is perhaps the most persuasive of the three, and that is the

fact that the assets of the business are already understated. Some of them are

recorded like the intangible assets that we talked about in an earlier lecture,

many of them are recorded at historical cost, they appear to be much smaller on

their balance sheet than they really are. So why should we have to show our debt

at current value, if we're showing our assets at their old historical value, or

not showing it at all? It makes our balance sheet lopsided, so

if we can shift a little bit debt off the balance sheet, then it makes it more

fair, and we get a better picture of what our company really looks like, because

we've made both assets and liabilities look a little smaller. Whether you

believe these arguments or not, companies have a lot of legal means, or financial

accounting means to legitimately remove their debt. It might not be ethical, but

it is legal, or legitimate from an accounting perspective, however you want

to think about it. So one of the best ways that companies can still do this is

with their leases. Leases, of course, are a long-term agreement to rent something

from a different company, but if we structure it just right, we don't

show that as a liability, we just debit a rent expense, and credit cash every

period as we send our checks. So even if you're locked in to a 10 or 20 year

lease, you can still not show that obligation on your balance sheet if you

follow the rules just right. A lot of companies have been very careful to

structure their leases so they follow these different roles, and slide off the

balance sheet. One of the best examples of this is one, I believe we mentioned

before, and that is FedEx. We've all seen the FedEx trucks, the planes, etc. None of

those show up on FedEx's balance sheet as assets, and the liability that they have

for leasing all of these items, don't show up as liabilities either. So leasing,

again, is one of those common ways that companies eliminate debt from their

balance sheet. Now in addition to the legitimate, or legal, ways that companies

that can slide debt off their balance sheet, there's also some ways that are

much closer to the border, and the best examples of these actually come from

Enron. Now Enron was a great energy trader. It had a lot of things going for it,

but slowly its culture shifted so that they started using accounting tricks,

instead of legitimate business practices to make a profit, and to keep their

balance sheet looking good. So there are many many examples of the ways that they

would keep debt off their balance sheet. We're gonna look at just one simple

example, and you'll see quickly just how complex some of the others had to be, if

this is simple. So let's start off with Enron. Enron needed a lone, and they were

worried about getting this loan, because they didn't want the extra debt on the

balance sheet. They didn't want to violate a debt covenant, or drive up some of their

ratios, so what they did instead is they created this special purpose entity. Now

a special purpose entity is a special kind of company, basically what it boils

down to is two different companies, or an individual and a company, getting

together and saying, you know, we need extra widgets. Nobody out there is

producing the widgets that we need, I don't have the money to do it, you don't

have the money to do it, what if we each put up just half the money, and we'll

create this special entity that only produces widgets? Now if we produce it

and it loses money, that's okay we're only on the

hook for half of the money that it loses, and if it makes money, at least we'll get

half of a gain, this could be a really good thing for us. Well one of the

negatives of a special-purpose entity is the fact that if you own half, and I own

half, but neither of us controls it. And from an

accounting perspective, since nobody has control, it just kind of disappears, and

nobody really shows this entity, or its assets, and that's what Enron was trying

to use. Not the special purpose, let's do something that's good for us

portion of a special purpose entity, but instead, let's find a way to make this

disappear, and then that's what they did with these entities, and they did quite a

few of them, and by structuring them so that Enron owned half and one of their

employees owned half, then they still essentially controlled this

special-purpose entity. So in order to create the special purpose entity, in

this example where they needed a loan, they took the asset they wanted use for

collateral, and they used it to help found this special-purpose entity, and in

exchange they received a bunch of stock from this special-purpose entity, which

gave them their voting control, then what they did with that stock is they went to

another special-purpose entity, that they didn't create, this one was already

out there, but they took the stock, not the voting stock, but like preferred

stock, where you were entitled to a dividend, but you don't didn't really

have any voting rights, and they sold that stock to this other special-purpose

entity. Well, the special purpose entity says oh yeah, we'd absolutely love to buy

this stock from you, it's a great idea for us as an investment, but we don't

have the cash right now, so let's go to the bank and we'll get

the bank to loan us the cash, and we'll then give that cash to Enron. Well the

bank looked at this loan, and they went, you know, this really is kind of risky, I

mean, all you have is some stock in another small company, remember this is

not Enron's stock, this is the special purpose entity one's stock, and the bank

was a little worried about it, and they said, you know, that special-purpose entity one

stock, I don't know if they're really going to produce enough value to repay

this debt. So Enron stepped in with what we call a derivative, and a derivative,

basically, is a way to offset risk, and essentially Enron guaranteed

that they would cover any defaults in the interest that this special-purpose

entity to had to pay to the bank, and the bank said, well, if we've got a derivative

that ensures that the interest will be paid, alright we'll accept that. And they

would loan the money to special purpose entity two, which would then give the money

to Enron. Now if you look at what's happened here, Enron has really used an

asset as collateral for a loan. That's what's really going on, but because of

the way they structure that, they not only avoid showing the loan, but they get

to show sales revenue from sailing off this stock to the subsidiary. Not only

they rid of the debt, they get to show revenue for this, and they don't even

have an interest expense to worry about later on, they just have to cover the

interest payments if special purpose entity two can't quite make them. Ingenious,

isn't it? You've got to wonder, as you think through this transaction and others that

were much more complex, and how well Enron would have done as a business if

they'd spent their time and intelligence and creativity providing business

services, instead of accounting tricks. Now since Enron took such advantage of

this special purpose entity opportunity, under the old GAAP rules, FASB

has actually closed this loophole, and you can't just make these entities

disappear anymore. So slowly but surely, we're finding ways to reduce company's

opportunities to get the balance sheet free of some of this debt. One of the

other ways we've done it, or are working on doing it, closing this loophole, is

we're trying to restructure the lease accounting rules, so that everybody has

to, what we call capitalize their lease, which would mean that you would show the

asset, and you would show the lease liability. That one's still very much up

in the air, there's a lot of pushback against what FASB's proposing, so

we'll see what happens, but because of companies like Enron, we are trying to

close some of these loopholes. Now despite company's attempts to shift

financing off of their balance sheet, there are some good ways that we can use

to analyze our debt, and how much debt a company's carrying, and perhaps the best of

these is the debt to equity ratio. Now the debt to equity ratio is basically

the total liabilities, divided by the total

equity. What we're showing is: how many dollars of debt we have for every dollar

of equity. That's the best way to interpret it, so if you have a million

dollars in liabilities, and a million dollars in debt, you have a ratio of one

one dollar of debt to every dollar of equity. Most investors want to see some

long-term debt, they want to see some one term debt because they want to know that

you're leveraging their money to make them more money. If I can take out a loan,

I don't have to you the money from the investors, and if I can make more than

the interest payment, then that profit rolls back to the investors, the owners,

and that's what any owners want to see. But they don't want to see too much of

it, so a smaller value is in this debt to equity ratio is usually considered less

risky, but most of us don't want to see it as zero, they want to see it around

one, perhaps maybe about 1.5, it depends on the industry how much debt

they'll actually be able to take out. The higher the industry risk, say trying to

invent new medicines, or other chemicals, there's a lot of risk there, so they

can't get a lot of debt, if it's a low-risk investment like, say, utility,

then you tend to see a lot higher debt to equity ratio, because there's really

no risk. People aren't going to stop buying electricity or water, so you have

a pretty good cash flow, and you can take out a lot of debt without a lot of risk,

since your future cash flows will be pretty steady, and then you can leverage

that and make investors more money. There's a lot going on with long-term

debt, why? Because long-term debt is such a big piece of understanding our

financial structure. Remember, these are our other investors. We have owners that

are investors in the company, and we have these long-term debt holders there are

other investors in our company, and we have to keep track of what we owe them,

and how much we need to pay them interest, and when we have to pay them

back, and how their investment matches up with what the owners have given us, it's

cool stuff, and it all works together so well to provide a good picture, even when

companies try to slide some of it off of their balance sheet. Now when we come

back in our last lecture, we're going to talk about our last set of investors, and

that is: our owners. The ones we typically think of as investors. That's what's coming up next.

I'll see you then. Thanks